The sideways scenario

Canadian market valuations are historically high, says Kim Shannon, so don't expect a sustainable bull market any time soon.

Sonita Horvitch 18 February, 2010 | 12:41AM
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Kim Shannon, president and chief investment officer of Toronto-based Sionna Investment Managers Inc., says that the equity market is likely to continue to be range-bound for the foreseeable future.

"Characteristic of such sideways markets is that they are of long duration and that there is huge volatility during their persistence." The market can reach new record highs during such periods, but these high points are generally followed by a significant pullback, she says.

Sionna considers that the equity market has been range-bound since the bursting of the tech bubble in 2000. "History has shown that this type of market can persist for a minimum of 15 years," says Shannon, who was Morningstar Canada's Fund Manager of the Year in 2005.

These sideways markets only end, says Shannon, when the price/earnings multiple for the market as a whole declines significantly, "typically to single-digit levels." This provides the foundation for a new secular bull market, she says. "The reduction in the P/E ratio over time comes predominantly from earnings growth, and this is a slow process."

(The Canadian benchmark S&P/TSX Composite Index is currently trading at a price/earnings multiple of 19 times trailing earnings, versus its historic average of 14 times.)

Founded by Shannon in mid-2002, Sionna Investment Managers, which specializes in Canadian markets, has $2.8 billion in assets under management. It offers mutual funds in conjunction with Brandes Investment Partners & Co., includingBrandes Sionna Canadian Equity  andBrandes Sionna Canadian Balanced.

An analysis of the big picture shapes Sionna's shifts in sector emphasis. Bottom-up stock selection is based on relative value. As part of this discipline, Sionna calculates a stock's intrinsic value based on historical book value, return on equity and its P/E ratio relative to that of the market.

Brandes Sionna Canadian Equity has assets of $630 million and 40 names. It has representation in all the 10 sector groups, with weightings generally at plus or minus 5% of the sector's weighting in the benchmark. The normal cash level is 5% to 7% and it is currently at the higher end of this range.

 
Kim Shannon

This fund has an underweight position in the financial services sector at 27.5% versus 30.5% in the index. Starting in the summer of 2007, on concerns about unfolding credit crisis, Shannon and her team shifted from an overweighting in the banks to an underweight position.

The Canadian banks as a group are expensive, she says. Their profitability, as measured by return on equity, is under pressure. Bank tax rates are rising. Also, the market for securitization of assets is "moribund." In the past, the asset securitization by the banks has provided a big boost to revenue, she says.

The only bank that Brandes Sionna Canadian Equity is overweight in is Bank of Nova Scotia BNS. This bank, she says, "has a consistent top-management culture which is stronger than the individual." It has one of the best efficiency ratios, given its low cost structure. Finally, it has a substantial and growing presence in emerging economies where the penetration of banking is low. "By contrast, Canada is a mature market for banking services."

Energy represents 28.5% of the fund versus 27% in the index. The largest holding in Brandes Sionna Canadian Equity is senior oil and gas producer Canadian Natural Resources Ltd. CNQ. The company, says Shannon, is an excellent operator. Its 100%-owned Horizon Oil Sands Project, 70 kilometres north of Fort McMurray, Alberta, is coming into full production and will be a strong free-cash-flow generator.

The company can use this cash flow to pay down the debt accumulated to build the Horizon Project, Shannon notes. Canadian Natural Resources is one of the few participants in the Canadian oil sands with a project that "came in on time and on budget." The valuation on the stock is "attractive." The stock trades at a price to book value of 1.9 times, the same as for the market as a whole. "We estimate that CNQ's intrinsic value is $86 a share."

Shannon and her team have been paring their holding in the major Canadian integrated energy company, Suncor Energy Inc. SU, though it remains a top 10 holding. The fund also held Petro-Canada, which was acquired by Suncor last year. As a result of the recent trimming, Suncor's weight in the portfolio is now similar to its weight in the benchmark.

Materials constitute 15% of the fund and 19.25% of the index. In this sector, a stock that Shannon and her team consider to be cheap is global methanol producer and marketer Methanex Inc. MX. "The company probably has one of the most underrated management teams in the materials sector."

Methanex has constructed a 1.3-million tonne per year production facility at Damietta on the Mediterranean coast in Egypt. It has a 60% interest in this joint venture. This company, says Shannon, is a "free-cash-flow machine, especially once its Egyptian plants are fully operational." The stock trades at a price-to-book-value per share of 1.7 times versus 1.9 times for the market as a whole.

The fund has some 10% in gold stocks, which is a modest underweight relative to the index. "It is unusual for a value manager to have a significant weighting in gold stocks as they tend to be expensive on traditional metrics, but we are relative value managers and see gold as an important store of value," Shannon says. The shift to a market weight in gold took place in mid-2007, at the same time as the bank overweight was taken to an underweight position.

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Sonita Horvitch

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